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Level 47

Hirshleifer Uncertainty


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Give an example of a hidden action versus a hidden knowledge type of situation.
Hidden action: When a principal employs an agent to carry out actions whose outcomes are uncertain - for example, when an absentee landlord engages a farm manager - the latter will evidently be …
What is the goal in both hidden action and hidden knowledge models?
In each case the challenge facing the lesser-informed party is to design an incentive scheme (a contract) aimed at mitigating the effects of informational asymmetry.
In the principal-agent (hidden action) model, what characterizes the efficient contract?
The efficient contract is one which, holding constant the expected gain of the agent, maximizes the principal's expected gain.
when both the principal and agent are risk-neutral.
Under what assumptions is there a payment scheme such that the efficient action can be achieved even where x is not directly observed?
Adverse Selection.
In a simple insurance example where individuals differ in probability of suffering loss L, but that these loss-probabilities are not subject to influence by the individuals' actions, are we dealing with a situation of adverse selection or moral hazard?
When hidden knowledge results in adverse selection, who suffers? How does this work in the insurance context?
When hidden knowledge results in adverse selection, those sellers with a product or service of above-average quality suffer from inability to secure a suitable price. In the insurance context, better-quality insureds may remain ou…
Who has an incentive to signal product quality? When is an action a signal?
Above-average sellers of a product priced out of a market with adverse selection may have an incentive to seek alternative, indirect ways of signaling product quality to be able to spread their risks.
Which side of the market screens?
Buyers seek some way of < screening > products of differing qualities.
High-quality risk-classes are more willing to buy partial coverage.
Who is willing to buy partial coverage (insurance with a "deductible")?
It maximizes expected profit by offering each risk class full coverage at a cost that extracts all consumer surplus.
Suppose there are two risk classes. What would the insurance company do if it can distinguish these risk classes < ex ante > ?
When does the insurance company optimally offers no insurance to the good risks?
When the proportion of poor risks get sufficiently high, the good risks are no longer offered insurance on favorable enough terms to be accepted by them. That is, adverse selection occurs.